Horse breeding - the latest taxation office feedback - July 2007

In light of the current ATO Racing Industry Audit, whether a horse business is considered a "Business" or "Hobby" remains the overwhelming "hot topic" in the world of horse taxation.

The interest in this topic will no doubt intensify in the next few months when the ATO issue a new draft ruling relating to the racing industry, a ruling that will cover this topic to a far greater degree than any other ATO pronouncement previously issued. This ruling was due for release in May 2007, but alas, the tax community still eagerly awaits its release. Guaranteed, my next article will explain the new draft ruling in great detail.

You don't necessarily have to speculate as to whether, in the event of an ATO audit, your horse activity would be considered a "business" by the ATO. The ATO have in place a "Private Ruling" system that allows a breeder to seek the ATO's opinion before the activity is commenced or a tax return lodged. A private ruling is broadly an expression of the ATO's opinion of the way in which a relevant provision applies, or would apply, to an entity in relation to a specified scheme.

If the ruling is favourable, relying on the ruling will provide an entity with protection from additional primary tax, penalties and interest. If the ruling is favourable, but is subsequently found to be incorrect, the ATO is bound by the ruling to the extent that it is relied upon. An entity will have objection, review and appeal rights against the ruling if it is not favourable.

What is not well known about the private ruling system is that the ATO publishes private ruling decisions on their web site. The Register of private binding rulings is an historical public record of written binding advice the ATO has issued to specific entities.

Note – each ruling is based on the facts of a specific situation as advised to the ATO and care must be taken if trying to adopt the ruling to your own circumstances. The private ruling is binding on the ATO only in relation to the specific entity named in the written binding advice and some material facts that formed the arrangement on which the ATO advice was given may have been removed or altered for privacy, secrecy or confidentiality reasons.

Whilst we await the issue of the new ATO draft ruling, I believe it will interest many to know details of the private ruling the ATO have published relating to only Horse Breeding activities, especially as it relates to whether an activity is a business or hobby. My comments on this ruling will also be provided.

HORSE BREEDING– ATO PRIVATE RULING DECISION

Ruling 1 – ATO Authorisation Number 65282

What this ruling is about:

Whether horse breeding activities constitutes the carrying on of a business activity.

Decision:

Not considered to be a "business".

Year(s) of income or period(s) to which this ruling applies:

Year ended 30 June 2005

Commencement date of scheme:

1 July 2004

Subject and facts of the ruling:

Three broodmares have been acquired for prices varying from $16,000 to $43,000. The previous offspring of two of the brood mares have sold for average prices in excess of $38,000 and $41,000 respectively.

All the broodmares are agisted at a commercial stud.

All mares are bred to local commercial stallions or interstate if appropriate, on a regular basis.

The applicant frequently attends the stud for the purposes of inspection. The applicant has given up full time employment which allows significant time to be devoted to completing research on stallions for the purpose of making the selections for breeding purposes.

All eligible progeny born to the mares have been sold commercially.

The applicant has developed a comprehensive business plan, setting out a breeding program, the market you are targeting and cash flow projections.

The applicant obtains expert advice from stud masters and a bloodstock agent.

The intention is to produce progeny that can be sold for around three times the stallion service fee. This is sufficient to cover the costs of service fees and rearing of foals to sale stage. An average price of $30,000 is required and this is achievable based on average prices from the yearling sales you have targeted. The applicant has projected a positive cash flow for the 2007 year.

The applicant intends to increase the number of broodmares by either further purchases or using your own bred fillies.

Reasons for ATO decision (extract from ruling):

Number, quality and turnover of horses

These would not be considered to be high value broodmares, as high value broodmares could have values in the range of $200,000 to $500,000.

The mares are served regularly by stallions that have a service fee in the range of $7,000 to $12,000. Again these are not the top of the range stallions in terms of service fees that could be $40,000 upwards.

This breeding program is set out in your business plan. You intend to produce progeny that can be sold for around three times the stallion service fee. This is sufficient to cover the costs of service fees, rearing the foals and reasonable level of veterinary costs, based on sale averages at the selected yearling sales.

You have provided a Cash Flow Statement showing the breeding activity should start returning profits from the 2007 year onwards. This is based on an average selling price of $30,000 with an allowance of 15% for skipping/slipping.

The positive return in 2007 is based on the sale of three offspring. Your statistics of broodmares and progenies show that the numbers sold or to be sold are:

2005 2 2006 1 2007 3 [estimate])

In 2005 only two offspring were sold due to an injury to one of the yearlings while being prepared for the sales; 2006 there is one sale as two of the broodmares slipped a foal; for 2007 there are 3 foals at foot to be prepared for sale.

The holding of only three mares of this quality may be too low a number to be able to consistently produce three yearlings for sale each year, which is the required number to meet the average expenses each year. The returning of a profit in the 2007 year has not come about not because of a gradual build up of the business but the fact that there were three yearlings sold.

It is considered that a larger number of broodmares of this quality are required for the activity to be consistently potentially profitable.

Reasons for ATO decision (extract from ruling):

Businesslike operation

You have both given up full time employment, allowing significant time to be devoted to, completing research on stallions, inspecting horses, visiting studs and attending sales. Advice is sought from stud owners and a bloodstock adviser.

You have developed a business that is constantly reviewed, to ensure the commercial goals are achieved. The business plan includes a breeding program, setting out the principles, risks and industry expertise requirements, as well as Cash Flow projections.

It is considered that the activities were undertaken in a systematic way. Records were kept, advice was sought and the breeding has occurred on a regular basis. From the information provided, the activities reflect a business like operation.

Profit-making intention

In considering whether the facts support an intention of profit, following points can be noted:

The brood mares have been specifically acquired for the purpose of breeding with the intention of selling the offspring commercially to the public;

One horse was raced to establish their credentials and the others were proven broodmares with previous yearling offspring averaging $38,000 and $41,000;

You have incurred $86,500 capital expenditure on acquiring brood mares, service fees of between $7,000 to $12,000 for each mare, each year and the use of quality management and facilities for which you pay substantial agistment fees;

Brood mares are sent to commercial stallions to be served;

You sell all available progeny and have targeted a specific market, to make your activity economical; and

You seek expert advice from stud farms and bloodstock agents to make appropriate decisions and are following a business plan.

It is considered from these facts that you have taken the necessary steps to make the activity potentially profitable when it is of sufficient scale.

Assets

Whether a taxpayer conducts an activity on their own property is not a decisive factor. Taxpayers may be considered to have a horse-breeding business even if they do not own property or stables. Conversely, if they own a stud farm they may still not be viewed as being engaged in a business.

What is important in the present case where the infrastructure is not owned by the taxpayer, is that considerable time and money has been expended in engaging the expertise and facilities necessary to conduct a horse breeding business.

Level of success

You have already sold three yearlings at an average price of $18,600, with the latest being sold for $31,000. Your business plan is reliant on getting an average price of $30,000. The sales so far suggest that this is possible with the correct bloodline selections the average price can be obtained.

The level of offspring of 2, 1, and 3 that have been produced over three years to be presented at sale indicates that even though you have made an allowance of 15% for skipping/slipping, a higher percentage may need to be allowed for all factors that may prevent yearlings being presented at sale each year.

Summary of Business Indicators

The operations appear to be carried out in a systematic and organised manner and the appropriate records are kept and maintained. The number and quality of brood mares held at 30 June 2005 appears to be to low for the activity to potentially produce a profit on a consistent basis. The "large or general impression" is one of an operation which has the potential to build up to a viable level with an increase in broodmare numbers, but is not of sufficient scale at present.

After considering all the factors above, on balance it is considered that you are not carrying on a business of horse-breeding during the 2005 income year.

Accordingly, any receipts associated with the activities are not assessable under Section 6-5 of the ITAA and any deductions are not allowable under Section 8-1 of the ITAA 1997.

It is considered that the activities should be reviewed annually to determine whether there has been sufficient change for the activity to be considered a business.

Comments:

Based on the facts published, I note:

This "no" decision a little contentious given the business-like manner that the applicant went about this activity, this point the ATO justifiably acknowledged (e.g. use of experts, record keeping, regularly mating of mares etc);

ATO relying on the "6 mare" rule, a rule they may not strictly use too much longer (per ATO feedback I have);

Based on case law, this would have been a decision worthy of appeal. Remember, this is only the ATO's opinion based on a specific set of facts;

High value mares do not have to cost "$200,000 to $500,000" to be viable to an operation. Given my current dealings with the ATO, many in their office would now accept this. For instance, mares can cost less than $20,000 but have a market value of $200,000 plus on the back of their subsequent breeding history or that of close relatives (e.g. full or half sisters);

Stallion service fees do not have to be above “$40,000” per mare for commercial foals to be produced. This opinion again conflicts with most of the case law in this area, which is of real concern;

The fact that this activity has a "reasonable profit expectation" going forward appears to have been given little acknowledgment by the ATO. I suspect an expert witness in an AAT or court hearing could put up a very strong "viability" case;

Not owning a breeding property was not a real factor in this case;

It can take five or six years for a breeding activity to become viable, a point even acknowledged by a member in a well known 1996 AAT case on this issue (breeder was successful too);

If you are going to run a small breeding herd, ensure you have mares that can consistently generate foals for sale. Small mare numbers coupled with poor breeding histories not the perfect mix. I still believe the ATO took a very harsh position with this case given that the sale of limited foals in this period was due to factors outside the control of the taxpayer and is not unusual for a breeding activity. The AAT and courts would have given this fact a far greater weighting than the ATO;

Impressed by the strong profit intention of this applicant, supported by their leaving full employment to pursue this activity; and

This case emphasizes how difficult it can be to get breeding cases approved by the ATO, given their current administrative position in rarely accepting breeding businesses with less than 6 mares (unless the mares are exceptional).

In fairness to the ATO, their private ruling register also has a breeding and racing case that was accepted as a "business" (see ATO Authorisation Number 36192). Relatively speaking, it was not a difficult case to rule on given the mare numbers (greater than 6 mares) and the quality of these mares.

You are welcome to contact me if you wish me to clarify or expand upon any of the matters raised in this article.

Any reader intending to apply the information in this article to practical circumstances should independently verify their interpretation and the information's applicability to their particular circumstances with an accountant specialising in this area.

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